The decentralized finance (DeFi) sector is growing at an exponential rate. The reason for this is largely centered around liquidity pools (smart contract-based protocols) and liquidity providers (end users who provide capital). Here's how liquidity works in DeFi.
Since the inception of decentralized finance (DeFi), liquidity has been a driving factor for user adoption. DeFi is a concept that combines both liquidity pools and liquidity providers, making it possible for anyone to become a virtual bank. Users deposit and lend funds in order to produce higher Average Percentage Yields (APYs) than traditionally available through banks. There are now hundreds of DeFi protocols reproducing all the functions of a bank on a blockchain.
In 2019, the value locked in these protocols was less than $1 billion. In April 2022, it is over $230 billion, a monumental increase in a relatively short amount of time. Find out how such an economic explosion happened.
Key Takeaways – Advantages and Disadvantages of Liquidity Pools
Advantages
- Allow anyone to provide liquidity and gain yield (APY) on their crypto balances.
- Make it easier for traders to complete DEX spot trades at real-time market prices.
- Use publicly viewable smart contracts, helping to improve transparency around security audits.
Disadvantages
- Impermanent loss - liquidity providers may actually lose real value by locking funds into a pool.
- Pools of funds are often controlled by one person or a small group, which isn't true decentralization.
- Many liquidity pools have suffered from large security breaches due to insecure smart contracts or flashloan attacks, resulting in huge losses for liquidity providers.
What Is a Liquidity Pool?
A liquidity pool is a kind of smart contract application deployed on a blockchain, mimicking a bank's process of giving interest in exchange for depositing assets.
To fully understand what a liquidity pool is, we must be clear about the importance of liquidity itself. Whenever traders enter any market, they rely on the market's liquidity. Without available liquidity, it is much harder to buy and sell assets, with potentially either side seeing unfavorable price conditions based on demand.
However, there are few institutional market makers to provide liquidity within the blockchain space. For instance, JP Morgan, the world's largest bank, is also a market maker (a.k.a. liquidity provider) when it comes to exchanging fiat currencies on the forex market, holding a 10% market share, but not for cryptocurrencies.
If you were to exchange USD for EUR, a market maker like JP Morgan would be the intermediary that would give a quote for ask and bid prices as well as supply liquidity. Without liquidity, traders would have to wait for their orders to be fulfilled until counter-party traders make the matching offer. By that time, the price of the asset itself might shift! This is where liquidity pools come in to replace such centralized market maker mediators.
If you've been reading carefully so far, you already see where this is going. In the blockchain space, there are no institutions like JP Morgan or Citadel Securities to that act as a liquidity provider, leaving that duty up to everyday users looking to optimize their ROI. Decentralized Finance (DeFi) relies on users, cryptography, and smart contracts to create liquidity. Specifically, smart contracts create DeFi liquidity pools.
Therefore, when you deposit your crypto funds into a DeFi liquidity pool, you effectively become both ends of a bank. This is the power of decentralized finance! Now, your funds are locked into the liquidity pool for a specified time, and other traders can tap into them, either for cryptocurrency trading between token pairs or borrowing.
As you would expect, any time you lock your crypto funds into a liquidity pool, you become a liquidity provider (LP). This is the essence of yield farming, with liquidity pools as yield farms and liquidity providers as yield farmers.
How Does a Liquidity Pool Work?
There are many popular liquidity pools powered by decentralized exchanges across different blockchain networks. On Binance Smart Chain, PancakeSwap is the most popular, while on Ethereum, SushiSwap exchange, Uniswap, Maker, Curve, and others hold the bulk of the market share.
Let's take the Uniswap exchange as an example, one of the oldest, most established, and well-known decentralized exchanges, largely responsible for pioneering and popularizing the concept of liquidity pools as the backbone of decentralized finance. If we head over to Uniswap Liquidity Pools and list the ranking by trading volume, we would get a predictable outcome. The most popular liquidity pools consist of token pairs involving stablecoins and ETH, Ethereum's native coin (and the second-largest cryptocurrency). Ethereum is also the largest smart contract platform with the greatest number of dApps and NFT marketplaces.
Because people need to convert from crypto to fiat and vice versa, stablecoins are always a hot commodity. They avoid inherent crypto volatility while still being crypto assets that offer all the benefits of blockchain technology. If we enter the USDC/ETH liquidity pool, we get all the info needed to become liquidity providers.
As you can see, 161.63 million USDC (equal to USD) is available to exchange for 12.91k ETH, and vice versa. If you were to connect to that liquidity pool via a MetaMask wallet, you would add liquidity to both sides of the trading wall. For this valuable service as a liquidity provider, you earn APY (annual percentage yield), drastically higher than one can achieve in any bank savings account with near-zero interest rates.
However, automated market makers like Uniswap do have some issues. One concept many traders on lower liquidity trading pairs face is known as slippage. Slippage is the difference between the expected price and the actual price once the transacted exchange is completed, meaning value can be lost for traders.
Furthermore, one should be wary of impermanent loss, a potential byproduct of providing liquidity to a LP pool and having one of the tokens go up in value. In this case, you may get less of the valuable token (although the same cash value as you initially deposited), introducing additional risk.
The Role of Crypto Liquidity Roles in DeFi
Given that central banks have forced commercial banks to set negative interest rates across Europe, it is no wonder that DeFi protocols have experienced such explosive growth in under two years.
If you have ever wondered where to stake your crypto assets, DeFi is a growing sector with plenty of great options to choose from. Although becoming a liquidity provider can be risky, as the old adage goes, "No risk, no reward."
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